interest rates


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From Bill Gross

I and others however, have for several years now, suggested that the primary problem lies with zero/negative interest rates; that not only do they fail to provide an “easing cushion” should recession come knocking at the door, but they destroy capitalism’s business models — those dependent on a yield curve spread or an interest rate that permits a legitimate return on saving, as opposed to an incentive for spending. They also keep zombie corporations alive and inhibit Schumpeter’s “creative destruction” which many argue is the hallmark of capitalism. Capitalism, almost commonsensically, cannot function well at the zero bound or with a minus sign as a yield. $11 trillion of negative yielding bonds are not assets — they are liabilities. Factor that, Ms. Yellen into your asset price objective. You and your contemporaries have flipped $11 trillion from the left side to the right side of the global balance sheet. In the process, you have deferred long-term pain for the benefit of short-term gain and the hopes that your ancient model renormalizes the economy over the next few years. It likely will not. Japan is the petri dish example for the past 15 years. Other developed market economies since Lehman/2009 are experiencing a similar fungus.

Investors should know that they are treading on thin ice. The problem with Cassandras, such as Gross and Jim Grant and Stanley Druckenmiller, among a host of others, is that we/they can be compared to a broken watch that is right twice a day but wrong for the other 1,438 minutes. But believe me: This watch is ticking because of high global debt and out-of-date monetary/fiscal policies that hurt rather than heal real economies. Sooner rather than later, Yellen’s smooth shot from the fairway will find the deep rough.

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James Grant, Wall Street expert and editor of the investment newsletter «Grant’s Interest Rate Observer», warns of a crash in sovereign debt, is puzzled over the actions of the Swiss National Bank and bets on gold.

From multi-billion bond buying programs to negative interest rates and probably soon helicopter money: Around the globe, central bankers are experimenting with ever more extreme measures to stimulate the sluggish economy. This will end in tears, believes James Grant. The sharp thinking editor of the iconic Wall Street newsletter «Grant’s Interest Rate Observer» is one of the most ardent critics when it comes to super easy monetary policy. Highly proficient in financial history, Mr. Grant warns of today’s reckless hunt for yield and spots one of the biggest risks in government debt. He’s also scratching his head over the massive investments which the Swiss National Bank undertakes in the US stock market.

About James GrantJames Grant, financial journalist and historian, is the founder and editor of «Grant’s Interest Rate Observer», a twice-monthly journal of the investment markets and must read for financial professionals. A former Navy gunner’s mate, he earned a master’s degree in international relations from Columbia University and began his career in journalism in 1972, at the Baltimore Sun.

He joined the staff of Barron’s in 1975 where he originated the «Current Yield» column. Mr. Grant is the author of several books covering both financial history and biography. His latest book, «The Forgotten Depression: 1921 – The Crash That Cured Itself», was published at the end of 2014. Mr. Grant is a 2013 inductee into the Fixed Income Analysts Society Hall of Fame. He is a member of the Council on Foreign Relations and a trustee of the New-York Historical Society. He and his wife live in Brooklyn. They have four grown children.Jim, for more than three decades Grant’s has been observing interest rates. Is there anything left to be observed with rates this low?


Interest rates may be almost invisible but there is still plenty to observe. I observe that they are shrinking and that the shrinkage is causing a lot of turmoil because people in need of income are in full hot pursuit of what little of yields remains.

What are the consequences of that?
It reminds me of the great Victorian English journalist Walter Bagehot. He once said that John Law can stand anything but he can’t stand 2%, meaning that very low interest rates induced speculation and reckless investing and misallocation of capital. So I think Bagehot’s epigraph is very timely today.

John Law was mainly responsible for the great Mississippi bubble which caused a chaotic economic collapse in France in the early 18th century. How is the story going to end this time?
It will turn out to be very bad for many people. If Swiss insurance and reinsurance executives are reading this right now they might be rolling their eyes and they might be frustrated to hear an American scolding from a distance of 3000 miles about the risk of chasing yield. After all, if you’re in the business of matching long term liabilities with long term assets you have little choice but to wish for a better, more sensible world. But you have to take the world as it is and today’s world is barren of interest income. The fact is, that these are very risk fraught times.

Where do you see the biggest risks?
Sovereign debt is my nomination for the number one overvalued market around the world. You are earning nothing or less than nothing for the privilege of lending your money to a government that has pledged to depreciate the currency that you’re investing in. The central banks of the world are striving to achieve a rate of inflation of 2% or more and you are lending certainly at much less than 2% and in many  cases at less than nominal 0%. The experience of losing money is common in investing. But where is the certitude of loss even before your check clears? That’s the situation with sovereign debt right now.

On a worldwide basis, more than a third of sovereign debt is already yielding less than zero percent.
There is not quite a bestseller, but a very substantial book called «The History of Interest Rates». It was written by Sidney Homer and Richard Sylla. Sidney Homer is no longer with us, but Richard Sylla is alive and well at New York University. So I called him and said: « Richard, I’ve read many pages but not every single page in your book which traces the history of interest rates from 3000 BC to the present. Have you ever come across negative bond yields?» He said no and I thought that would be kind of a major news scoop: For the first time in at least 5000 years we have driven interest rates below the zero marker. I thought that was an exceptional piece of intelligence. But I notice however that nobody seems to have picked up on it.

It’s now already two years ago since the ECB was the first major central bank to introduce negative rates.
There are some other historical settings: In Europe, Monte dei Paschi di Siena, this 500 and plus year old bank in Italy, is struggling and as broke as you can be without being legally broke. Monte dei Paschi has survived for half a millennium and now it is on the ropes. Meanwhile, the Bank of England is doing things today that it has never done in its history which is 300 plus years. So I suggest that these are at least interesting times and in many respects unprecedented ones.

So what’s the true meaning of all this?
In finance, mostly nothing is ever new. Human behavior doesn’t change and money is a very old institution and so are our markets. Of course, techniques evolve, but mostly nothing is really new. However, with respect to interest rates and monetary policy we are truly breaking new ground.

Now central bankers are even talking openly about helicopter money. Will they really go for it?
I already hear the telltale of beating rotor blades in the sky. I also hear the tom-toms of fiscal policy being pounded. There seems to be some kind of a growing consensus that monetary policy has done what it can do and that what me must do now – so say the «wise ones» – is to tax and spend and spend and spend. That seems to be the new big idea in policy. In any case, it is not good for bondholders.

Interestingly, nobody seems to be talking about the growing government debt anymore. Also, budget politics are just a side note in the ongoing presidential elections.
The trouble with this election is that somebody has to win it. I have no use for Donald Trump but I have equally no use for Hillary Clinton. The point is that one of those two is going to win. That is the tragedy! So we at Grant’s regret that one of them is going to win.

The financial crisis and the weak economic recovery likely have spurred the rise of Donald Trump. Why isn’t the US economy in better shape after all those monetary programs?
I wonder how it would have been if markets had been allowed to clear and if prices had been allowed to find their own level in real estate in 2008. Central banks have intervened to quell financial panics for at least 200 years. For instance, in 1825 the bank of England lent without stint and was not – as they said – overnice about the kind of collateral. That was a very dramatic intervention. So it’s not as if we have never before seen the lender of last resort at work. But what is new is the medication of markets through this opiate of quantitative easing year after year after year following the financial crisis. I think that this kind of intervention has not only not worked but it has been very harmful. Around the world, the economies are not responding despite radical monetary measures. To some degree, I believe,  they are not recovering because of radical monetary measures.

What’s exactly the problem with the US economy?
There is another side of what we are seeing now: In America certainly the Federal Reserve and bank regulators generally are very heavy handed in their interventions. I’m sure they have every good intention. But with their regulatory charges they are suppressing the recovery in credit that takes place  in a normal economic recovery and in this particular case after a depression or after a liquidation.

Then again, a revisit of the financial crisis would be catastrophic.
The new rules with respect to financial reform have absorbed not only forests worth of paper but also the time and attention of legions of lawyers. If you talk to a banking executive what you hear is that the banks have been overwhelmed by the need to hire compliance and regulatory people. This is especially bearing on the smaller banks. I think that’s part of the story of the lackluster recovery: Monetary policy has been radically open in the creation of new credit. But it has been radically restrictive with regard to risk taking in the private world.

So what should be done to get the economy back on track?
There are guides in history on how to do this. For more than a hundred years in Britain, in the United States and probably as well in Switzerland, the owners of the equity of a bank themselves were responsible for the solvency of the bank. If the bank became impaired or insolvent they had to stump up more capital to pay off the liability holders, including the depositors. But over the past hundred years collective responsibility in banking has gradually replaced individual responsibility. The government, with the introduction of deposit insurance, new regulations and interventions has superseded the old doctrine of the responsibility of the owners of a property. That’s why I think we need to go away from government intervention and go more towards market oriented solutions such as the old doctrine of responsibility of the bank owners.

At least in the US, the Fed is trying to go back to a more normal monetary policy. Do you think Fed chief Janet Yellen will make the case for another rate hike at the Jackson Hole meeting next week?
Janet Yellen is by no means an impulsive person. According to the « Wall Street Journal», she arrives for a flight at the airport hours early – and that’s plural! So this is a most deliberative and risk averse person. Also, as a labor economist, she’s a most empathetic person. She believes what most interventionist minded economists believe: They have very little faith in the institution of markets and they don’t believe that the price mechanism is anything special. They want to normalize rates and yet they can always find an excuse for not doing so. We have been hearing for years now that the next time, the next quarter, the next fiscal year they will act. So I believe what I’m seeing: None of these days the Federal Funds Rate will go higher than 0.5%. I can’t see that happening.

Wall Street seems to think along the same lines. So far, many investors don’t take the renewed chatter of a rate hike too seriously.
The Fed is now hostage to Wall Street. If the stock market pulls back a few percent the Fed becomes frightened. In a way I suppose, the Fed is justified in that belief because it is responsible to a great degree for the elevation of financial asset values. Real estate cap rates are very low, price-earnings-ratios of stocks  are very high and interest rates are extremely low. One can’t be certain about cause and effect. But it seems to me that the central banks of the world are responsible for a great deal of this levitation in values. So perhaps they feel some responsibility for letting the world down easy in a bear market. It has come to a point where the Fed is virtually a hostage of the financial markets. When they sputter, let alone fall, the Fed frets and steps in.

Obviously, the financial markets like this cautious mindset of the Fed. Earlier this week, US stocks climbed to another record high.
Isn’t that a funny thing? The stock market is at record highs and the bond market is acting as if this were the Great Depression. Meanwhile, the Swiss National Bank is buying a great deal of American equity.

Indeed, according to the latest SEC filings the SNB’s portfolio of US stocks has grown to more than $60 billion.
Yes, they own a lot of everything. Let us consider how they get the money for that: They create Swiss francs from the thin alpine air where the Swiss money grows. Then they buy Euros and translate them into Dollars. So far nobody’s raised a sweat. All this is done with a tab of a computer key. And then the SNB calls its friendly broker – I guess UBS – and buys the ears off of the US stock exchange. All of it with money that didn’t exist. That too, is something a little bit new.

Other central banks, too, have become big buyers in the global securities markets. Basically, it all started with the QE-programs of the Federal Reserve.
It is a truism that central banks do this. They’ve done this of course for generations. But there is something especially vivid about the Swiss National Bank’s purchases of billions of Dollars of American equity. These are actual profit making, substantial corporations in the S&P 500. So the SNB is piling up big positions in them with money that really comes from nothing. That’s a little bit of an existential head scratcher, isn’t?

So what are investors supposed to do in these bizarre financial markets?
I’m very bullish on gold and I’m very bullish on gold mining shares. That’s because I think that the world will lose faith in the PhD standard in monetary management. Gold is by no means the best investment. Gold is money and money is sterile, as Aristotle would remind us. It does not pay dividends or earn income. So keep in mind that gold is not a conventional investment. That’s why I don’t want to suggest that it is the one and only thing that people should have their money in. But to me, gold is a very timely way to invest in monetary disorder.

 

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Negative interest rates are unsustainable and once investors decide to stop paying for the privilege of holding government debt, a banking crisis could result, says James Grant.

The founder of Grant’s Interest Rate Observer was one of several speakers at the New York Society of Security Analysts (NYSSA)’ Annual Benjamin Graham Conference to remark on the ramifications of unprecedented loose monetary policy.

Historic Lows

Central banks are treading in uncharted waters. Sidney Homer and Richard Sylla, the authors of A History of Interest Rates, found no instance of negative rates in 5,000 years. Now there are $11.7 trillion invested in negative-yield sovereign debt, including $7.9 trillion in Japanese government bonds and over $1 trillion in both French and German sovereign debt.

Grant posed a tongue-in-cheek question: “If these are the first sub-zero interest rates in 5,000 years, is this not the worst economy since 3,000 BC?”

This is not a bad economy by most measures. Household wealth in the United States has grown steadily since the Great Recession. If these gains were the result of greater productivity, interest rates would not need to stay at historic lows. Grant says they are “a sign of someone’s thumb on the currency.” Negative rates are propping up risk assets. He critiqued US Federal Reserve chair Janet Yellen’s touting of the bull market in equities as a sign of prosperity by alluding to Brexit voters.

“Asset prices have failed to pacify the world’s unprofitable voters,” Grant said.

The War on Cash

Investors have fallen into the trap of thinking that the future will be like the past, Grant says. The period of falling yields and rising bond prices that began in 1981 is entering its 35th year. He noted that a 35-year bear market preceded this. Yet the yield curve for Swiss bonds is sub-zero for the next 30 years, thereby implying that investors expect negative rates to persist for a long time.

Another reason to think rates must begin to rise: Bonds with negative yields are worse investments than cash. That has always been the reason for zero lower bound in monetary policy. So far, investors have been willing to pay for the convenience and security of storing wealth in banks and bonds, but if yields become sharply negative, some savers will no longer be able to accept guaranteed compounded losses. Then, conventional wisdom says, they will hoard cash, which returns 0%.

To maintain increasingly lower interest rates would require a “war on cash,” Grant said. He envisions a means by which the Fed would discourage and stigmatize using cash, and ultimately implement an unfavorable exchange rate on physical currency.

Central Bank Acrobatics

Central bankers have taken the evolution of currency from a measure of value to a macro-policy tool to, and perhaps beyond, its limits, Grant says. A federal funds rate below zero charges banks to store deposits at the central bank. These negative rates are passed on to depositors, which incentivizes them to spend rather than save. To avoid paying negative rates, banks and individuals buy bonds, so yields fall below zero when demand and price spike.

These “central bank acrobatics” create distortions, like inflated equity prices. Another example: Italian 10-year notes yield roughly 20 basis points (bps) less than US notes. If this is not evidence of the European Central Bank (ECB)’s currency manipulations, Grant said, then investors must expect “a return to the glory of Rome.” Even as the pound fell 12% after Brexit, 10-year gilt yields fell below 1%.

“Where is the pushback from the market?” Grant asked.

Yellen has said the Fed could set the funds rate below zero in the event of a recession. Grant put the odds of sharply negative rates in the case of a recession at “perhaps not 60%,” but noted a confidence in negative rates among central bankers. After the Great Recession, a near-zero funds rate and quantitative easing (QE), which raised inflation expectations, had already reduced real yields to below zero.

Looming Crises

Though savers are yet to hoard cash in their mattresses, negative rates could have other consequences. Negative funds rates squeeze banks’ profit margins. Low enough rates could cause many to become unprofitable. Pension funds depend on bond yields to meet their payment requirements. Grant says it is now impossible for them to hit 7% return targets. Insurance companies invest their premiums in fixed income, and are “dying on the vine” according to Grant.

If interest rates rise due to inflation or pushback from the market, several countries could have difficulty coping with the higher costs of borrowing. Italian stocks tumbled after Brexit, indicating that investors may fear a debt crisis. Japan will have even more difficulty disposing of its debt. Japan has the highest debt-to-GDP ratio in the world atover 200%, in part due to Abenomics intended to prop up stock prices and inflation. Grant also thinks China’s wealth management products are a threat to default.

Gold: An Investment in Monetary Disorder

Grant acknowledged that gold is “the asset class of choice for calamity hounds,” but suggested that investors consider it. The case for gold, he says, has more to do with the state of money and credit than with Brexit. Grant characterizes the value of gold as the reciprocal of the world’s trust in central banks.

“Radical monetary policy begets more radical policy,” he said. “It seems to me, at some point, markets or voters will put a stop to this.”

If and when that time comes, investors will be looking for physical stores of wealth.

“The case for gold is not as a hedge against monetary disorder, because we have monetary disorder, but rather an investment in monetary disorder,” Grant said.

More Advice for Investors

Grant was not the only speaker to address the current condition of money and credit:

  • David Poppe on why value stocks have underperformed growth stocks: “Low interest rates have made it very cheap for companies to grow. Higher ROI will outperform when capital becomes more expensive.”
  • Jason Karp on dividend-paying stocks: “Retirement flow is coming from low rates because you can’t earn from bonds. Stocks have to be your bond proxy.”
  • Leon Cooperman, CFA, on the end of the bond bull market: “Buying bonds is like walking in front of a steamroller to pick up a dime: You might get away with it, but it’s very risky . . . there’s no coupon to bail you out.”

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Capital markets are information engines. When functioning properly, they reflect what investors know – or think they know – about the future. Future expectations are for all to see, discounted in today’s financial prices. Obviously, this doesn’t mean that capital markets are always “right,” for the future comes as it will, caring not a whit whether it was the one we ordered up or not.

For the first time in recorded history, financial interest rates have gone negative. To say this makes no sense is almost tautological. Nobody pays to have their Amazon delivery delayed or their Uber pickup deferred. Consumption now is always prioritized over consumption later, which is why interest rates have been positive for centuries. Is there some set of future expectations that could possibly justify negative yielding debt?

Were an investor to accept that negative yields actually reflect future expectations, then the sovereign debt market must be calling for a ‘30s style price deflation! Go long canned green peas and head for the hills! Yet, is there not a fly in the ointment of this analysis? Stocks hitting record highs obviously do not reflect deflation expectations. Nor do investment grade corporate bonds yielding 2 ¾%. The risk markets violently disagree with the sovereign debt markets. Yet, how can it be that government bond yields are pathologically low while risk assets are priced atrociously high?

The Occam’s razor answer is this: the ECB, the BOJ, and yes the Fed too have blocked the capital markets from expressing their “unbiased” future expectations. Rather than let the capital markets reveal investor expectations, the central banks have imposed a pricing regime that reflects what the academics believe to be “better” outcomes.

This is scary. If negative rates are merely the latest in a long line of artifices the central banks have resorted to so as to make the risk carry trade profitable, then look out below! For once the central banks let go of the till (or have it pulled from their hands), this whole financially engineered dynamic goes careening into reverse.

Without active suppression by the central banks, the bond market will call off-sides on negative yields, and sovereign rates will surely “normalize” back to positive rates. But higher government rates will also force cap rates higher everywhere: in stocks, in real-estate, and in the real world where businesses calculate a demanded return in exchange for a capital allocation.

In the mind of the central banker, the capital markets must be stopped dead in their tracks whenever they threaten a “tantrum.” But, in so doing, capital markets are prevented from telling us what true market clearing levels are. And, without good information, coordination loses its effectiveness, leading to low growth and soggy productivity. Low growth – the consequence of inefficient resource use – then becomes the recurring justification for still more central bank rate suppression. The paradigm is not one of self-correction but of doubling down. Keep doubling down and rather than having a series of corrections, you might just end up with a crash.

Monetary central planning has not led to the uncorking of the champagne bottles. Instead, it has engineered a condition of overvalued asset prices now propped up by the absurdity of negative rates.

The Fed, et al. are riding the tiger of a great global carry trade. Some have called this the “new normal.” But it is anything but normal and it is also inherently unstable. How unstable?

While no one can say for certain, two metrics that have had a dispositive record of forecasting recession are (1) declining corporate profits and (2) progressively flatter yield curves. We have both:

There is really no mystery as to why these metrics matter. Lower profits force managements to defend their margins by curtailing business investment and by throttling back on hiring. The widening chasm between the “adjusted” earnings that companies report versus what their GAAP calculated earnings would be is yet another red flag. And, of course, flatter yield curves compress net interest margins making leverage less profitable. Less leverage means balance sheets shrink which forces a rationing of credit and a tightening of lending standards. The writing is on the wall.

Our central bankers took the till away from the markets years ago, confident that their policies would chart a course to El Dorado. Instead, they have sailed us off the map, into places that financial markets have never been, and should never be.

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This is the reason for a soaring stock market. Bonds as an asset class, have almost ceased to exist.

For pension funds, that need to generate a return, where do you go? Into dividend paying stocks, with a gamble on capital gains to boot.

It would be an interesting exercise to see inflows of stocks to pension funds. The pension crisis is written about, but so far has stayed fairly low key. At some point, it is going to become a major problem.

Possibly, people working longer, refusing to retire are the first signs of this issue. It is definitely something that I am increasingly aware of, and planning for.

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I haven’t had much time to write about economic theory in a couple of years, but this snippet is worth a response.

“People work in order to convert their time into a unit of account,” he said. “We call that money, and it’s an invention that allows us to store time.” Most people have stored little or none. So when they receive money, they quickly purchase necessities; food, shelter, health care. “People who are able to save money inevitably purchase real estate, stocks, bonds – all of which are alternative vehicles for storing time.” One share of Google stores 30 hours of work for the average American, or 30 minutes of copying-and-pasting formation documents for the average hedge fund attorney. “Bill Gates has stored enough time to fund a 1bln person army for 20 years.”

As the gulf between people’s income has grown, the amount of stored time has accumulated in fewer hands. “Wealthy people convert their hours into financial assets so that they can accumulate excess hours relative to their fellow man. But the average worker is simply thinking how to exchange hours for dollars and then exchange those for food.” Central banks face a different problem altogether. They need to get people who’ve saved time to exchange it for something other than clever inventions that store it. They’ve largely failed. So now, everything that stores time is extremely expensive and offers little or negative return, while the pace of economic activity slows. “The problem that we face now is that there is simply too much time that’s been saved. Another way of saying it is that there’s too much capital in the world, in too few hands.”

To restart the system, capital needs to exchange hands or be destroyed, spurring people to rebuild their store of time, rather than just save it. “It is an elemental truth that at some point, through inflation, war, or confiscation and redistribution, this imbalance will correct, and the system will then restart.”

The quote addresses ‘time preferences’. It addresses the choices available to any individual who is involved in an exchange of property rights. This is only addressed tangentially. Property rights are exchanged and stored as ‘money’. This rather begs the question, what exactly is money?

An individual can: [i] exchange money directly, [ii] hold money as cash, [iii] save [invest] money. These are all time preferences.

Investing requires free market interest rates. We do not currently have these as the Central Banks around to world seek to hold nominal interest rates low. There is still however the ‘natural rate of interest’.

In paragraph three, the author asserts that capital needs to be destroyed or change hands. Capital will likely be destroyed, but these are mal-investments.

Mal-investments  are predicated by artificially low nominal interest rates, which, we currently have and have had for quite some time, since the late 1980’s when Greenspan took over the Fed Chair.

Currently we are reaching the end game of artificial rates.

Of course should ZIRP/NIRP end, all business that exists because of these artificial rates, the mal-investments, will likely collapse, which is the destruction of capital that the author refers to.

This would almost certainly lead to a major bear market, which is the bear case. We saw a taste of it in 2008. The unemployment shot through the roof. There are not many ‘depression proof’ industries, the pain is felt everywhere.

Currently, the next internet/housing bubble is most apparent in social media, which relies on advertising revenue for almost 100% of its revenues. This is a problem and is a major destination of current mal-investments.

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The Fed wants to start the cycle higher. The markets are maybe not so happy.